Technology

Why Hewlett-Packard's Impulse Buy Didn't Pay Off

When Leo Apotheker took over as Hewlett-Packard’s (HPQ) chief executive officer two years ago, the company needed shock therapy. HP was stuck with a portfolio of slow-growth businesses—PCs, printers, and servers—and had missed major tech industry developments including smartphones, tablet computers, and online cloud-computing software. Apotheker believed that HP’s platform was sinking, according to a person familiar with the executive’s thinking, and likened this fabled Valley company to a dying animal. He “appeared to be in a hurry to transform the company,” says Robert W. Baird analyst Jayson Noland. “You can’t cut costs forever, and investors wanted to see growth.”

In a rapid series of moves announced in August 2011, Apotheker killed HP’s six-week-old TouchPad tablet, explored plans for a spin-out of its PC business, and championed the $10.3 billion acquisition of Cambridge (England)-based software maker Autonomy. One former HP executive who worked there at the time says it appeared that Apotheker and the board didn’t know what to do, and were trying anything they could think of. It wasn’t a strategy, he says. It was chaos.

Just how chaotic became clear when HP said on Nov. 20 that it will take an $8.8 billion writedown on the Autonomy deal amid allegations of accounting improprieties at the software company. The company says it’s referred the matter to the U.S. Securities and Exchange Commission and the U.K.’s Serious Fraud Office, and says it’s planning its own civil suits. Its board ousted Apotheker in late 2011, after only 11 months on the job, replacing him with Meg Whitman. Her job just got more challenging: Autonomy is now worth about 15 percent of what HP paid for it.

A look at Apotheker’s brief and inglorious tenure explains how HP miscalculated. Apotheker joined HP after a long and successful career at German software maker SAP (SAP). Although admired for his intellect (he speaks five languages) and drive, his autocratic management style sometimes hampered his decision-making, say many of the more than one dozen former HP and SAP colleagues interviewed for this story, who asked to remain anonymous due to their personal ties with him. By the time Apotheker had taken over, Autonomy, which makes products for organizing the reams of data flooding corporate computer networks, had been on the block for months and retained star investment banker Frank Quattrone of Qatalyst Partners to pitch a sale.

Quattrone and Autonomy CEO Mike Lynch first shopped the company to Oracle (ORCL) in a meeting last April. They didn’t name a price, but Oracle executives told them that Autonomy’s $6 billion market value didn’t seem justified by its financials, according to people with knowledge of the meeting who asked to remain anonymous because it was private. Oracle co-President (and former HP CEO) Mark Hurd concluded that Autonomy’s business was growing too slowly; mergers-and-acquisitions head Doug Kehring doubted Autonomy’s lofty profit margin, the people say. They didn’t take the company’s pitch seriously, the people add. In a conference call with analysts that September, Oracle CEO Larry Ellison called Autonomy’s asking price “absurdly high.”

Apotheker viewed Autonomy as HP’s ticket into the high-margin software market, which constituted less than 3 percent of HP’s sales at the time. The CEO and his chief strategy and technology officer, Shane Robison, hired accounting firm KPMG to review Deloitte’s February audit of Autonomy. A spokesman for Apotheker says he presented the acquisition to the board at a two-day meeting in late July 2011. The next month he countered objections from his chief financial officer, Cathie Lesjak, that the deal was too costly. Apotheker won the argument, and the deal went forward. (Lesjak declined to comment.)

Autonomy, which reported $395 million in operating profit on $931 million in sales in the 12 months before HP bought it, used aggressive accounting tactics to inflate its results, according to a former Autonomy executive who asked to remain anonymous because he didn’t want to be seen as criticizing an employer. Autonomy front-loaded and booked much of the revenue from a subscription software product called Zantaz, a Web-based program that banks and law firms use to archive computer files for compliance purposes. By recognizing payments at once rather than spacing them out over time, the company burnished its profit figures. Its accounting treatment of an e-mail- and document-archiving system, Arcpliance, exaggerated the true profit margin of the sale of the product, which wasn’t widely used, the executive says. In the software business, “revenue recognition is usually the predominant way to cook the books,” since its high profit margins make accelerating sales more tempting, says Dana Basney, director of due diligence and forensic accounting services at CBIZ MHM in San Diego. “You get more bang for the buck.”

Accounting standards are difficult to enforce in the software industry because of the difficulty of counting physical goods, says Michael Cusumano, a management professor at the Massachusetts Institute of Technology’s Sloan School of Management. About half of publicly traded software companies since 1990 have had to restate revenue because of misclassification of sales and product returns, or because they categorized ongoing payments for tech support services as a sale of a product license, according to Cusumano’s data. “You need to be doubly and triply careful in believing what you see on paper,” he says. “A lot of times, accounting firms are not experts in detecting these kinds of frauds. They can be pretty well-hidden.”

It was only after a whistle-blower from Autonomy stepped forward this spring that HP became aware of problems at the software maker. After the Autonomy disclosure, HP shares plunged to a 10-year low, extending a slide that’s wiped out more than $100 billion in market value in the past five years. Apotheker and Whitman defend the vetting that took place before the Autonomy deal. In a statement he issued on Nov. 20, Apotheker called the company’s due diligence procedures “meticulous and thorough” and the accounting scandal a “shock.”

Whitman, whom HP did not make available for an interview, told analysts during HP’s fourth-quarter earnings call that the board relied on the audited financials of Deloitte and KPMG. Deloitte declined to comment for this article; KPMG says its only role was to provide a limited set of nonaudit-related services. Deloitte “obviously didn’t catch these issues at the time,” says HP General Counsel John Schultz. “It was difficult if not impossible for HP to catch them.” Schultz says Autonomy misstated more than $200 million in revenue—including booking sales of PCs and computer mice as software. Lynch told Bloomberg News his methods conformed to European accounting standards, and HP leveled its charges to paper over mismanagement of the unit. “It just doesn’t add up,” he says. “HP is looking for scapegoats, and I’m afraid I’m not going to be one of those.”

HP has an uneven history of acquisitions. Its investors have been disappointed by its takeovers of Palm, whose webOS phones and tablets never hit, and Electronic Data Systems, which was outmaneuvered by IBM (IBM) and Indian outsourcing firms in IT services.

Photographs by Bloomberg; AP Photo

The company is still profitable, and its $10.6 billion in cash flow for the fiscal year ended Oct. 31 outpaced Walt Disney (DIS), FedEx (FDX), McDonald’s (MCD), and Visa (V). Whitman faces the same big strategic challenges that confronted Apotheker. HP is up against more profitable rivals IBM, Oracle, and Cisco Systems (CSCO) in business computing, and is sandwiched between Apple (APPL) and Chinese PC maker Lenovo in the consumer PC market. When she took over from Apotheker last fall, she was seen as a calming influence following a period of tumult. It may not work out that way.